Fastenal (FAST) is no longer moving fast, but it remains a steady outperformer in a huge unconsolidated MRO market. The consistent outperformance, an asset light business model and great predictability makes it a very desirable investment.
The good news for (prospective) shareholders is that shares have been lagging for years now, even as revenues continued to grow, albeit at a lower pace. This means that valuation multiples have come down, although shares continue to trade at a premium compared to the overall market.
That said, the strong track record, growth opportunities, steady nature of operations and great cash flow conversion, all support the investment thesis. If shares dip towards the mid-thirties, I will be glad to initiate a stake into this well-run business.
Not So Fast, Still Outperforming
Fastenal is a growth story in an unconsolidated MRO market with an annual size of $140 billion in North America alone. The company sells fasteners under its namesake brands as well as non-Fastenal products to industrial and construction related businesses.
Sales are made through industrial vending machines, onsite locations, national accounts and own stores. Notably national accounts is a key growth area for the business as smaller stores will be closed if they are not economical, with sales being diverted towards national account and nearby stores.
The company will celebrate its 50th anniversary next year, as it has shown consistent and remarkable growth in the past, accompanied by very compelling margins. Fastenal has delivered impressive operational gains over the past decade as revenues more than doubled from $1.8 billion in 2006, towards $3.9 billion in 2015.
Margins have ranged anywhere between 18 and 22% of sales, currently trending towards the middle of the range. With the exception of 2009 when margins fell towards +15% amidst the depth of the recession, margins are extremely stable and high.
The modest margin gains, the fact that sales more than doubled, and modest share repurchases have benefited shareholders handsomely, at least in terms of earnings per share. Earnings hit a peak of $1.77 per share in 2015, as Fastenal traditionally operates with a very strong balance sheet.
While growth has surely slowed down in 2015, and is actually even more challenged in 2016, it should be said that Fastenal's shares have been stagnant for quite a while now. After peaking in the $50s in 2012, shares generally traded in the range of $35-$50 ever since.
While growth is slowing down, valuation multiples have come down over time, amidst continued progress in terms of both revenues and earnings.
The woes in the energy industry have affected the overall MRO market which has posted negative sales growth so far this year, but Fastenal continues to outperform the overall industry. It actually reported growth for the month of September in the Gulf Coast region, something encouraging after a rough time for that geographical area. While there are some encouraging signs and Fastenal continues to grow, it surely cannot escape the headwinds entirely. It too is reporting sluggish growth while margins are coming under a bit of pressure.
First-quarter sales growth came in at 3.5% as daily sales increased by 1.9%, with the latter metric being similar to "comparable" sales growth rates. It should be said that the weak Canadian dollar did shave off 80 basis points of the daily sales growth number in the first quarter of the year.
Second-quarter sales growth slowed down to 1.6%, entirely driven by daily sales growth as currency headwinds alleviated to 40 basis points. Following these soft second-quarter results, third-quarter revenues were up by 1.8%, again entirely driven by daily sales growth. This modest acceleration in growth can be explained by the continued lessening impact of a weak Canadian dollar, this quarter only subtracting 10 basis points from the reported sales growth.
Somewhat encouraging is the 2.8% growth rate being reported for the month of September. In traditional fashion, Fastenal is very forthcoming with providing information to its investors.
While these growth numbers are very modest, they do indicate that Fastenal continues to outperform its peers and the wider industry, as in particular heavy OEMs and non-residential construction companies face a difficult year.
Margins Come Under Pressure
Slower growth and declines in the overall industry are increasing competition and even Fastenal cannot escape that, while lower margin non-fastener categories are growing quicker than the profitability of core fasteners. Gross margins compressed by 120 basis points in the third quarter, as margins remain impressive at 49.3% of sales. Operating margins fell by 2.2% to 19.9% on the back of gross margins compression, higher healthcare costs and investments into distribution infrastructure and other initiatives.
The combination of margin pressure and very modest revenue growth hurts earnings, although a lower effective tax rate has been a tailwind, accompanied by modest share buybacks. Third-quarter earnings are down 3 cents, coming in at $0.44 per share. For the first nine months of the year, earnings are down 5 cents compared to last year, now trending at $1.33 per share.
With 2015's annual earnings reported at $1.77 per share, it is likely that earnings are set to fall this year, although modestly. If earnings come in at $1.70, it is hard to call shares very cheap at $38 per share, for a 22 times multiple. Net debt stands at $300 million and while the company would certainly shy away from reporting EBITDA metrics, let alone adjusted metrics, leverage is very modest at 0.3 times EBITDA.
Relative Appeal Lures
Let me point out, a 22-times earnings multiple is not very cheap, even if Fastenal has a rock solid balance sheet and continues to outperform its peers. This earnings multiple translates into an earnings yield of merely 4.5%, although the very low capital intensity of the business allows for a 3.1% dividend yield at $38 per share.
While the earnings multiple is not cheap in absolute terms, Fastenal trades at a roughly 20% discount in terms of sales, EBITDA and earnings compared to its ten-year average, on the back of shares being stagnant for quite a while, as underlying revenues kept rising, although at a lower pace.
While it seems odd to pay a 20% premium, in terms of multiples compared to the overall market, for a firm which is facing harsh times, Fastenal has some key advantages. This includes great cash flow conversion, continued market share gains as well as stable and high margins.
In my eyes the strong business model gives the company a key advantage, allowing for fat margins even in a world in which Amazon.com (NASDAQ:AMZN) pretty much threatens all existing business models. The combination of relative low value of purchase and expertise needed, makes that the model seems resilient for now, although one can never rule out competition in the making.
Given the great balance sheet, track record of growth and stability, and very strong cash flow conversion, I will take a 5% earnings yield in the case of Fastenal. The corresponding 20 times earnings multiple translates into a targeted entry point around $35 per share.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.